Storms usher in an expensive new era

Saturday 1 October 2005 20.24 EDT
First published on Saturday 1 October 2005 20.24 EDT

When Tony Blair asked last week how long we were going to have to rely for energy on 'some of the most unstable regimes in the world', I trust he did not have Britain and North Sea oil in mind.

But he was certainly on the right subject. At last weekend's annual meetings of the World Bank and International Monetary Fund in Washington DC, all conversations led to, or began, with the subject of oil.

The meetings started with reports that Houston, Texas, of all places, had run out of gasoline. Luckily, the damage wreaked by Hurricane Rita was less than feared, but problems with refining capacity in the Gulf of Mexico are such that the US is relying on extra shipments of imported oil from Europe, so that its disturbing balance of payments deficit, already 6.5 per cent of gross domestic product, is likely to get even worse in the short term.

The extent of the latest oil shock was described in dramatic terms by Gordon Brown in his capacity as chairman of the IMF's key policy committee, when he pointed out that the price of oil had doubled in the past 12 months and trebled since 2002. The price has also doubled in real terms (after allowing for general inflation) and is now around the peak reached during the second oil shock of 1979-80, which plunged the world into recession.

The good news is that, in the words of the IMF's latest world economic outlook, 'Global oil intensity is now about 38 per cent lower compared with the late 1970s, implying that any increase in crude oil prices will necessarily have a lower first-round negative effect on global growth.' This reflects both efforts at conservation by energy users and the shift to 'services', which are not such heavy users of energy as traditional basic industries.

Nevertheless, the world economy remains deeply dependent on oil, and the implications of the recent rise are serious. For Brown, it is a double blow: despite his enlightened efforts to secure debt relief for Africa, the financial benefits for many countries will be dwarfed by the higher price of imported oil.

And, at a time when the inevitable ravages of the business cycle, and monetary tightening by the Bank of England, have caught up on the longest British economic recovery since Julius Caesar's road-building programme, how the Monetary Policy Committee reacts to the new level of oil prices will be crucial to our chances of avoiding a general recession.

The higher price of oil is not exactly good news for the eurozone either. Germany in particular has been experiencing an export-based recovery and a related increase in business investment; the problem, of course, has been a lack of spending by the people economists like to call 'consumers'. If there is one major economy where higher oil prices may bestow a benefit, it is Japan, which has recently emerged from a long period of deflation, and where a little extra inflation is just what the doctor ordered.

In the US the visitor notes that gasoline pump prices - only $1 a gallon a few years ago - have recently been up to $3 and above. But even during a weekend visit one could see that the hurricane-induced rises in the price were being reversed, and there were widespread reports that Americans were at last cutting down on car journeys.

Higher oil prices, by transferring income from consumers of oil to producers, lower what economists call 'aggregate demand', because the industrial countries tend to spend most of their income, whereas history suggests that it takes time for the Opec group to spend sudden gains. Higher oil prices increase the costs of production in the industrial world and lower profit margins, a process which raises the average price level and can cause what are known as 'second-round effects' as employees respond by negotiating higher wages.

This raises the question of how governments and central banks respond to such potentially inflationary influences. In the 1970s some countries, not least Britain, 'accommodated' the rise in the price of oil, and we had rip-roaring inflation, from which the Callaghan government of 1976-9 never recovered. A senior international monetary official recalls, incidentally, that when Britain was forced to apply for financial help from the IMF in 1976 the financial markets, in the general panic, did not seem to notice that North Sea oil was just around the corner, and would finance the repayment of any balance of payments debts.

This official, a member of the IMF's executive board at the time, recalled last week: 'I saw no problem in approving the IMF loan. With North Sea oil in prospect, I could not see what the fuss was about.'

Well, North Sea oil is well past its peak (but not, luckily, its sell-by date) and there are those futurologists who point to a 'world without oil' later in this century.

There is some way to go before we reach this point. But it is fascinating that the most senior of senior international monetary officials in Washington spent a lot more time talking about oil than they did about interest rates. The consensus seemed to be that there would be an easing of pressures on the oil price in the short term after Hurricane Rita, but that the good old days were gone - forever.

This was not a 'supply shock' in the sense that the immediate cause lay not with Opec policy (as in 1973-74) or in a politically induced withdrawal of supplies by Iran, as in 1979.

No, everybody agrees that, in the words of one official, China, India and others are now behaving like us and consuming vast quantities of oil. It is demand that has driven the price up, not action by Opec, which, on the contrary, has been almost wholly beneficent.

But there is a supply side aspect to this shock, and that is the shortage of refining capacity, not least in the gas-guzzling US, where refining capacity has not risen since 1976. Then there is the gap between the vast size of known reserves of oil, and the capacity to supply current demand on the ground.

US officials complain that, while some of the western oil companies have been more concerned with profit and satisfying their shareholders than with new investment, the Opec group, especially in the Middle East, has been - surprise, surprise - more concerned with energy policies and budgetary targets that suit its own interest than with the appetite of - I was going to say the west, but of course we now include the east.

There are long time lags between the start of investment in new facilities for extracting oil from the ground and beneath the sea and refining capacity, and actual production.

This suggests that the price of oil will remain high for quite a time - the experts say five years or so - before new investment influences it, although who knows what the supply and demand balance will be by then, or what stage fears of global warming will have reached.

A conclusion that comes out loud and clear from studies by the IMF is that, pace some commentators, the higher price of oil is not an artificial one to be blamed on wild speculators. 'The causality tests imply that speculative activity follows movements in spot prices, thereby raising doubts about speculative activity being a key driver of spot prices.' That is intelligent bureau-speak for 'Don't fool yourself.'

Which brings us back to the implications for economic policy. There is one hell of a debate within the Bank of England and elsewhere, with the hawks arguing that, with higher oil prices built into the system, there is a limit to which the impact on prices should be accommodated when central banks make their decisions about interest rates.

We shall hear more on this subject in the coming weeks. In particular, aficionados are all agog to see what the governor Mervyn King says in his next speech.

Meanwhile, I wish to share with readers the greeting I received from the great Professor John Galbraith, due to celebrate his 97th birthday this month, when I called on him in his Cambridge, Massachusetts, home on my way back.

The great man is old; but 'Frailty, thy name is not Galbraith.' Recalling the influence of the oil lobby in the invasion of Iraq to safeguard oil supplies (sic), Galbraith said: 'The Labour Party should not have associated with Bush.

'Bush is an aspect of something that goes much deeper. The economy is dominated by the large corporations ... our military operations both at home and abroad, including notably Iraq, are under corporate direction through Rumsfeld and a compliant military staff. In the absence of corporate initiative and power we would not be in Iraq. And, a more poignant matter, we would not have George Bush!'